Using ETFs To Access Alternatives

The introduction and rapid expansion of the ETF industry has no doubt been a very positive development for investors big and small. The low fees characteristic of the exchange-traded structure have allowed cost-conscious investors to minimize expenses without sacrificing returns, while the enhanced tax efficiency and intraday trading capabilities have contributed increased flexibility to the investing public.

As ETFs have gained traction with investors, the size of the product lineup has grown rapidly. What was relatively recently a few hundred funds offering exposure to “plain vanilla” stock and bond benchmarks has quickly grown to an ever-growing line of exchange-traded products covering nearly every nook and cranny of the investable universe. This proliferation of ETFs has given investors more precise tools for accessing traditional asset classes, but it has also opened up investment strategies and asset classes that were previously either out-of-reach or that required considerable time and/or expenses to implement properly [also see ETF Alternatives To The World's Largest Mutual Funds].

The vast majority of the $1 trillion-plus invested in U.S.-listed ETFs is in funds that offer exposure to well known indexes, such as the S&P 500, MSCI Emerging Markets Index, or BarCap Aggregate Bond Index. But one of the fastest-growing corners of the ETF market focuses on alternative asset classes. A number of different strategies and types of securities fall under the “alternatives” umbrella, with different objectives and potential uses. In general, alternatives are useful not necessarily for huge expected returns, but for low correlations with traditional asset classes–which gives them value as diversifying agents when added to stock-and-bond portfolios.

Below we profile several different ETF options that go beyond the traditional classes and offer exposure to alternatives [for more ETF insights, sign up for our free ETF newsletter]:

Volatility

The CBOE Market Volatility Index, better known as the VIX, is a widely-followed gauge of expected market volatility over the coming month. Computed using prices for put and call options on the S&P 500 Index, the VIX is widely followed by many traders and can be used to measure investor anxiety over the short term outlook for U.S. stock [see the Guide To Volatility ETFs].

Because the VIX tends to spike when equities are sinking or anxiety is running high, it has been dubbed the “fear index.” The strong negative correlation between the VIX and equity markets means that there is potential value as a diversifying agent, but historically investing in the VIX has been tricky. Because the index is computed using prices of other securities, a direct investment isn’t possible. In 2004, VIX futures began trading on the CBOE, and options were introduced two years later. In early 2009, iPath introduced the first VIX ETNs, making this asset class available to all types of investors.

Investors have embraced volatility, and the Volatility ETFdb Category has grown to include 15 different products. Among the innovations within this asset class:

iPath’s VXX is the most popular volatility option, as it measures first and second month futures on the VIX.

UBS offers a long/short VIX ETN that seeks to exploit nuances of the VIX futures curve; XVIX maintains long exposure to mid-term futures partially offset by a short position in short-term futures [see A New Twist On Volatility].

VelocityShares offers leveraged VIX ETNs, tools that will generally be appropriate for more sophisticated investors.

It’s important to note that these volatility ETPs don’t offer exposure to the spot VIX (Citi does offer an ETN linked to a non-VIX measure of volatility). Rather these products are linked to futures-based indexes, in much the same way as many of the exchange-traded commodity products. Because the market for VIX futures is often in steep contango, there will often be considerable deltas between the returns to VIX ETPs and a hypothetical spot investment in the VIX [see VIX ETFs: Reviewing All The Options].

Hedge Fund Replication

Some investors are skeptical of ETFs that purport to deliver hedge fund-like strategies, since the transparency of the exchange-traded structure and passive indexing approach don’t seem to be consistent with the tactics of Paulson, Soros, and other legendary managers. But the products in the Hedge Fund ETFdb Category don’t pursue aggressive strategies in an attempt to deliver shoot-the-lights-out returns; rather they are more similar to the original hedge funds that sought to deliver non-correlated returns and add value in both bull and bear markets [see Closer Look At Hedge Fund ETFs].

Within the hedge fund ETF space, there are a number of different options. The broad QAI seeks to replicate the risk-adjusted return characteristics of hedge funds using various hedge fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage and emerging markets. Other funds offer more targeted exposure; MNA and CSMA implement a merger arbitrage strategy, while MCRO offers exposure to a macro strategy.

Compared to traditional hedge funds, hedge fund ETFs offer a number of potential advantages. Hedge funds positions are often expensive (the “2 and 20″ fee structure is common) and illiquid, whereas the exchange-traded products offering exposure to these strategies are cheap (the average for the Hedge Fund ETFdb Category is just 70 basis points) and incredibly liquid [see Hedge Fund ETFs vs. Hedge Funds].

Managed Futures

Managed futures strategies have been around for decades, but recent innovation in the ETF space has brought this technique within reach for all types of investors. WisdomTree’s Managed Futures ETF (WDTI) is actively managed, seeking to correspond closely to the Diversified Trends Indicator. That benchmark is a composite of 24 highly liquid futures grouped into 14 sectors, with an even split between financials (i.e., currencies and interest rates) and physical commodities. The positions of each sector are either long or short (except for energy) based on price behavior relative to a moving average (if energy is not positioned long, the sector weight is allocated to other sectors). Sector weights are determined by global production for commodities, and by GDP tiers for financials.

Because the managed futures strategy allows for both long and short positions it has the potential to deliver positive returns in any type of market; in 2008, when equity and commodity markets cratered, the DTI was up more than 8% [see Inside The Managed Futures ETF].

iShares also offers an option for exposure to managed futures; the Diversified Alternatives Trust (ALT) uses three general strategies to generate returns:

Yield and Futures Curve Arbitrage

Technical Momentum/Reversal

Fundamental Relative Value

Long/Short

Market neutral investing, which consists of identifying relative mispricings and establishing both long and short positions, is nothing new. But pursuing such a strategy has never been easier, as there are now multiple ETFs that offer exposure to long/short strategies–including both passively indexed and actively managed funds.

The idea behind this technique is relatively straightforward: managers seek to identify securities that are mispriced relative to one another, going long in the relatively cheap security and short in the relatively expensive one. Because the net exposure is zero (i.e., market neutral), this strategy has the potential to gain in both up and down markets and can be expected to exhibit little to no correlation with stocks or bonds [read The Long And The Short Of ETF Investing].

ProShares’ RAFI Long/Short fund (RALS) seeks to exploit inefficiencies associated with market capitalization weighting. The index underlying RALS consists of long positions in stocks with RAFI weights greater than their market cap weight and short positions in stocks with market cap weights greater than their RAFI weight. RALS has come flying out of the gates, delivering non-correlated, positive returns during its brief history.

There are other options as well; the actively-managed Mars Hill Global Relative Value ETF (GRV) is an ETF-of-ETFs that established both long and short positions in sector-specific and country-specific funds, while the ELEMENTS S&P CTI ETN (LSC) offers exposure to a long/short strategy revolving around commodity futures.

Short Only

There are a number of ETFs in the Inverse Equities ETFdb Category that offer short exposure to stock indexes, and AdvisorShares recently launched the first actively-managed product in the group. The Active Bear ETF (HDGE) focuses on forensic accounting, seeking to identify companies that utilize aggressive accounting methodologies in order to boost short-term results. The management team uses a combination of qualitative and quantitative analysis in an attempt to identify candidates for short selling [see Closer Look At The Active Bear ETF].